Sunday, August 26, 2007

Michael Lewis, writing in the Times magazine, profiles John Seo, one of the new generation of quant hedge fund managers. Seo trades catastrophe bonds, instruments that let insurers and reinsurers transfer risk from natural disasters. An interesting point discussed later in the article is that the typical premium charged for rare event insurance (tail risk) is about 4-5 times the expected loss, and that this rough rule of thumb is found across many different kinds of risk.

Seo's path to finance is a typical one for physicists in my generation, including the objections from his traditional Asian family :-) People often ask me why I am interested in quant finance. If the majority of friends you knew in college and graduate school (all of them brilliant and highly trained scientists) ended up doing something different than you, wouldn't you naturally be curious about what they were up to? The most common sentiment I've heard expressed by former physicists who are now in finance is "I can't believe I waited so long to leave"!

Whatever image pops to mind when you hear the phrase “hedge fund manager,” Seo (pronounced so) undermines it. On one hand, he’s the embodiment of what Wall Street has become: quantitative. But he’s quirky. Less interested in money and more interested in ideas than a Wall Street person is meant to be. He inherited not money but math. At the age of 14, in 1950, his mother fled North Korea on foot, walked through live combat, reached the United States and proceeded to become, reportedly, the first Korean woman ever to earn a Ph.D. in mathematics. His father, a South Korean, also came to the United States for his Ph.D. in math and became a professor of economic theory. Two of his three brothers received Ph.D.’s — one in biology, the other in electrical engineering. John took a physics degree from M.I.T. and applied to Harvard to study for his Ph.D. As a boy, he says, he conceived the idea that he would be a biophysicist, even though he didn’t really know what that meant, because, as he puts it, “I wanted to solve a big problem about life.” He earned his doctorate in biophysics from Harvard in three years, a department record.

His parents had raised him to think, but his thoughts were interrupted once he left Harvard. His wife was pregnant with their second child, and the health plan at Brandeis University, where he had accepted a job, declared her pregnancy a pre-existing condition. He had no money, his parents had no money, and so to cover the costs of childbirth, he accepted a temp job with a Chicago trading firm called O’Connor and Associates. O’Connor had turned a small army of M.I.T. scientists into options traders and made them rich. Seo didn’t want to be rich; he just wanted health insurance. To get it, he agreed to spend eight weeks helping O’Connor price esoteric financial options. When he was done, O’Connor offered him 40 grand and asked him to stay, at a starting salary of $250,000, 27 times his post-doc teaching salary. “Biophysics was starved for resources,” Seo says. “Finance was hurling resources at problems. It was almost as if I was taking it as a price signal. It was society’s way of saying, Please, will you start solving problems over here?”

His parents, he suspected, would be appalled. They had sacrificed a lot for his academic career. In the late 1980s, if you walked into the Daylight Donuts shop in Dallas, you would have found a sweet-natured Korean woman in her early 50s cheerfully serving up honey-glazed crullers: John’s mom. She had abandoned math for motherhood, and then motherhood for doughnuts, after her most promising son insisted on attending M.I.T. instead of S.M.U., where his tuition would have been free. She needed money, and she got it by buying this doughnut shop and changing the recipe so the glaze didn’t turn soggy. (Revenues tripled.) Whatever frustration she may have felt, she hid, as she did most of her emotions. But when John told her that he was leaving the university for Wall Street, she wept. His father, a hard man to annoy, said, “The devil has come to you as a prostitute and has asked you to lie down with her.”

A willingness to upset one’s mother is usually a promising first step to a conventional Wall Street career. But Seo soon turned Wall Street into his own private science lab, and his continued interest in deep questions mollified even his father. “Before he got into it, I strongly objected,” Tae Kun Seo says. “But now I think he’s not just grabbing money.” He has watched his son quit one firm to go to work for another, but never for a simple promotion; instead, John has moved to learn something new. Still, everywhere he goes, he has been drawn to a similar thorny problem: the right price to charge to insure against potential losses from extremely unlikely financial events. “Tail risk,” as it is known to quantitative traders, for where it falls in a bell-shaped probability curve. Tail risk, broadly speaking, is whatever financial cataclysm is believed by markets to have a 1 percent chance or less of happening. In the foreign-exchange market, the tail event might be the dollar falling by one-third in a year; in the bond market, it might be interest rates moving 3 percent in six months; in the stock market, it might be a 30 percent crash. “If there’s been a theme to John’s life,” says his brother Nelson, “it’s pricing tail.”

And if there has been a theme of modern Wall Street, it’s that young men with Ph.D.’s who approach money as science can cause more trouble than a hurricane. John Seo is oddly sympathetic to the complaint. He thinks that much of the academic literature about finance is nonsense, for instance. “These academics couldn’t understand the fact that they couldn’t beat the markets,” he says. “So they just said it was efficient. And, ‘Oh, by the way, here’s a ton of math you don’t understand.’ ” He notes that smart risk-takers with no gift for theory often end up with smart solutions to taking extreme financial risk — answers that often violate the academic theories. (“The markets are usually way ahead of the math.”) He prides himself on his ability to square book smarts with horse sense. As one of his former bosses puts it, “John was known as the man who could price anything, and his pricing felt right to people who didn’t understand his math.”

Friday, August 24, 2007

Two interesting videos, showing female faces in 500 years of Western art and in film.

I find both compilations visually fascinating. It is amazing how similar these nearly ideal female faces are to each other. We have pretty sophisticated hardwired capabilities for face-recognition; an alien species would probably conclude that we all look alike!

WSJ: In 1985, when I left academia and began putting my physics training to work on Wall Street, I talked eagerly about options theory to anyone who would listen. One lunchtime, I turned to a colleague in the elevator and began to babble about "convexity," a mathematical property of options crucial to the Black-Scholes theory used in derivatives pricing. My friend clearly understood convexity, but he shuffled his feet uncomfortably and quickly changed the subject. "Hey, futures dropped more than a handle today!" he said, imitating a genuine bond trader. It didn't take me long to recognize the source of his discomfort: I had just outed him as a fellow quant. Except back then we practitioners of quantitative finance didn't refer to ourselves as quants. That's what "real businesspeople" -- traders, investment bankers, salespeople -- called us, somewhat pejoratively.

Now the term is proudly embraced, as demonstrated by "How I Became a Quant," which collects 25 mini-memoirs of academics who successfully made the jump to Wall Street. Quantitative finance might have lost a little of its luster in recent weeks with the sub-prime mortgage meltdown and its subsequent deleterious consequences for quantitative trading strategies, but quants know -- as many of them in this book emphasize -- that however science- and math-based investment calculations might be, there is still an art to their use and plenty of room for error.

But definitions first. What is a quant, or, rather, quantitative finance? It is an interdisciplinary mix that combines math, statistics, physics-inspired models and computer science, all aimed at the valuation and management of portfolios of financial securities. In practice, for example, a quant might be presented with a convertible bond being issued by a corporation and, by extending the Black-Scholes model to convertible securities, calculate its probable value. Or he might develop a quantitative algorithm to buy theoretically cheap stocks and short theoretically rich ones.

By my reckoning, several of the 25 memoirists in "How I Became a Quant" are not true quants, and they are honest (or proud) enough to admit it. But many others are renowned in the quant community. To name just a few: Ron Kahn, co-author of the classic "Active Portfolio Management"; Peter Carr, an options expert at Bloomberg; Cliff Asness, one of the founders of AQR Capital; and Peter Muller, who ran statistical arbitrage at Morgan Stanley.

Most of the book's contributors belong to the first wave of a financial revolution that began in the 1970s, when interest rates soared, listed equity options grew popular and options traders began to rely on the mathematically sophisticated Black-Scholes model. Investment banks needed mathematical talent, and, as the academic job market dried up, physicists needed jobs. Many early quants were therefore physicists, amateurs who had happily entered a field that didn't yet have a name.

Today we are in the middle of a second wave. As markets became increasingly electronic-based, asset and hedge-fund managers began to embrace algorithmic trading strategies -- and started competing to hire quants, hoping to emulate the continuing successes of such firms founded in the 1980s as Renaissance Technologies and D.E. Shaw & Co. The establishment of the International Association of Financial Engineers, co-founded in 1992 by another contributor to this book, Jack Marshall, has further legitimized the field. Nowadays you can pay $30,000 a year or more to get a master's degree in the subject. Financial engineering has become a profession, and amateurs are sadly passé.

Most of the early quants -- in addition to physicists, they included computer scientists, mathematicians and economists -- came to the field by force of circumstance. Even if they had been fortunate enough to find a secure academic position, they often became weary of the isolating academic grind and found that they liked working at investment banks and financial institutions. As former SAC Capital Management quant Neil Chriss notes, Wall Street is no more competitive than academia. Life in finance is often more collegial than college life itself -- and more stimulating. It is impressive how many of the contributors here cite with awe their encounters with the late economist Fischer Black (1938-95), himself a Ph.D. in applied mathematics rather than economics, who always insisted that research on Wall Street was better than research in universities.

The memoirs in this book are not quite representative. That there are only two women contributors is proportionately accurate; most quants were male. But most quants were also foreign-born. When I ran an equity quant group in the 1990s, the great majority -- all with doctorates -- were from Europe, India or China. Only two of the memoirists grew up abroad in non-English-speaking countries. Quants in the second wave are still largely foreign-born, but more are women and fewer hold doctorates.

Several contributors to "How I Became a Quant" stress an essential point: Physics and finance are only superficially similar. While theoretical physics captures the essence of the material world to an accuracy of 10 significant figures, theoretical finance is at best an untrustworthy, limited representation of the mysterious way in which financial value is determined. Yet Thomas Wilson, the chief insurance risk officer of the ING Group, wisely remarks: "A model is always wrong, but not useless." Despite the inadequacies of quantitative finance, we have nothing better. And, on the practical side, Andrew Sterge, the chief executive of AJ Sterge Investment Strategies, writes: "The greatest research in the world does no good if it cannot be implemented."

Quants do get more respect these days, because their imperfect models can generate profits when used with a knowledge of their limitations. But quants can also produce awe-inspiring disasters when they begin to idolize their man-made models. Nevertheless, most quants, unless they have their own operations, are still second-class citizens on Wall Street rather than its superstars, and many still aspire to leave behind bookish mathematics and join the ranks of the "real businesspeople" who used to look down on them.

Wednesday, August 22, 2007

The WSJ interviews Peter Fisher, the man who led the Fed intervention during the LTCM crisis. He's now an MD at Blackrock.

WSJ: What similarities or differences do you see to previous market crises?

Mr. Fisher: Big market events that pose systemic risks tend to reflect collective mistakes in which most market participants are offside in the same direction. In the summer of 1998 there was a collective misunderstanding about credit risk: Everyone underestimated sovereign risk and lived in the fantasyland were sovereigns did not default. Remember? "Russia won't default, they have missiles." It turned out not be about missiles but about cash flows. It turned out that credit mattered and then we had to revalue a lot of sovereign paper that was being used as collateral.

WSJ: So in 1998, there were problems with collateral. And this time, there are even more problems with collateral, right?

Mr. Fisher: Yes, indeed. Until the week before last, nobody seemed to be focused on the uncertainty surrounding the value of mortgage-related and structured-finance paper and, then, suddenly, everyone did. The late MIT Professor Rudi Dornbusch sagely observed that in financial markets things always take longer to happen than you expect but once they happen, events unfold much more quickly than you expect and this perfectly describes the events of mid-August.

WSJ: The conventional wisdom was that globalization would lead to a dispersion of risk. And yet, the market seems so spooked with announcements of problems from Australia to Germany as well as in the U.S. How do you see the costs and benefits of globalization in the financial markets?

Mr. Fisher: The benefit of course is risk diversification and dispersion but this comes with an offsetting cost. This is the cost of proxy or imperfect hedging, where market participants sell what they can rather than what they wish, which leads to higher linkages and less benefit of dispersion. In 1998, after Russia's default, there was selling pressure in Mexican bonds not because the market thought a Mexican default was likely but because the Mexican bonds were liquid.

WSJ: What else feels different this time?

Mr. Fisher: In September of 1998 there were a lot fewer people who thought they saw a buying opportunity -- famously, in the case of LTCM, only Warren Buffett and Hank Greenberg. It took until October and November of that year for more people to see a buying opportunity and for the markets to find a bottom.

Tuesday, August 21, 2007

Abstract:Couplings between standard model particles and unparticles from a nontrivial scale invariant sector can lead to long range forces. If the forces couple to quantities such as baryon or lepton (electron) number, stringent limits result from tests of the gravitational inverse square law. These limits are much stronger than from collider phenomenology and astrophysics.

I can already see who the scapegoats will be for the subprime credit meltdown...

The mathematical models involved here are used to value bundles of mortgages or other debt, including corporate "junk" (high yield) bonds. Most importantly, they predict probabilities or rates of default based on historical data and the characteristics of the overall economy, the borrowers, etc. One problem is that rating agencies such as Moody's and S&P were willing to rate senior tranches of subprime debt as AAA (safe), based on the model predictions. In other words, their models predicted that only the riskier tranches would take significant losses and sufficiently senior tranches were as safe as, well, T-bills.

Now, the failure of default models based on historical data might have something to do with loosening of credit standards and outright fraud at the mortgage broker (mainstreet) level. That has little to do with eggheads and math, although perhaps the eggheads should have realized the frailty of human nature in advance :-) Also, there is some question as to whether S&P and Moody's were happy to nudge the ratings higher in order to drum up business. It is an inherent conflict of interest that ratings agencies are paid to generate ratings!

The second model problem is more subtle and plays a role in hedge fund strategies. The models predict relative changes in valuation in different tranches. If interest rates spike, or spreads change, the effect on the senior tranches might be very different from that on junior tranches or on equities. Hedge funds made bets on the correlations predicted by their models, but at least in the short term got into trouble because the market was indiscriminate in marking down all forms of credit, independent of quality. These trades may, in the long run, be big winners if the hedgies have sufficient liquidity to ride them out. Goldman (and some smart co-investors like Hank Greenberg and Eli Broad) and Citadel may have the brains, guts and liquidity to ride this out.

The credit industry is in the early stages of building a system to redistribute risk. This works quite well for us in, e.g., the insurance industry. But it would be naive to think that there won't be hiccups and crises along the way. At the moment, much of the problem is fear and contagion: the system is new and untested, and the participants are afraid.

Final comment: I doubt the typical market neutral quant long-short fund is directly involved with credit products. They lost money recently simply because the market moved in a very unpredictable way -- certain funds that did have credit exposure had to sell whatever liquid positions they had to make margin calls. That means stocks that quant models tended to favor suddenly and unexpectedly went way down...

For Wall Street's Math Brains, Miscalculations

Complex Formulas Used by 'Quant' Funds Didn't Add Up in Market Downturn

By Frank AhrensWashington Post Tuesday, August 21, 2007; A01

They are the powerful, cerebral and offstage actors of Wall Street, but the recent turmoil in the financial markets has yanked them into the light.

They are the math geniuses of the quant funds.

Short for "quantitative equity," a quant fund is a hedge fund that relies on complex and sophisticated mathematical algorithms to search for anomalies and non-obvious patterns in the markets. These glitches, often too small for the human eye, can present opportunities for short-and long-term trades that yield high-profit returns.

The models replace instinct. They try to turn historical trends into predictive science, using elegant mathematics seemingly above the comprehension of your average 401(k) participant or Wall Street fund manager.

Instead of veteran, market-savvy traders waving fistfuls of sell slips, the elite quant funds employ Nobel nerds with math PhDs, often divorced from the real world. It's not for nothing that they are called "black-box" funds -- opaque to outsiders, the boxes contain investment magic understood by only the wizards who conjured it up.

But the 387-point drop in the Dow Jones industrial average Aug. 9 and the continuing turmoil in the markets, in part attributed to massive sell-offs by the quant funds, have tarnished some of the quants' glimmering intellectual credentials and shown that, when push comes to shove, they can rush toward the exits as fast as a novice investor.

Last week, Goldman Sachs said its Global Alpha quant fund had lost 27 percent of its value this year because its computers failed to anticipate what the firm called "25 percent standard deviation moves" or events so rare Goldman had seen them only twice before in the firm's history. On the same day Goldman revealed the bad news, the firm said it would lead a group of big-money investors, including philanthropist Eli Broad, in pouring $3.6 billion into another Goldman quant fund, aiming to shore up confidence in the quants.

Barclays Global Investors, with $450 billion of its $2 trillion in assets under quant management, began applying mathematical tools to its funds in 1978. Last week, Barclays spokesman Lance Berg said the firm was "maintaining its investment process" despite the recent troubles. He would not say how much the Barclays quant funds had fluctuated during the period of turmoil.

The acknowledged quant king is James Simons, 69, an M.I.T.-trained mathematician with a groundbreaking theory that physicists are using to plumb the mysteries of superstring study and get at the very nature ofexistence itself. Simons turned his big brain on investing after his math career, founding Renaissance Technologies quant shop. The firm pocketed $1.7 billion in investor fees last year, among the highest in the industry. In return, his clients can reap annual returns of more than 30 percent, according to news reports.

As elegant as the models are, they cannot predict unpredictable events, or human panic, some traders say. Further, some say, too many quant funds are full of myopic brainiacs, overly reliant on their tools.

"Most are idiot savants brought to industrial proportion," Nassim Nicholas Taleb, former quant-jock and bestselling contrarian author, said by phone from Scotland, where he is promoting his new book on improbability, "The Black Swan."

"They are very smart in front of a textbook but not smart enough to understand very elementary things in reality," he said.

Taleb believes in monkey-wrench events that shatter the models of the quant-jocks. He says their algorithms don't adequately account for huge, rare anomalies, such as the current surprise credit crunch. Or the Russian credit crisis in 1998 that nearly put the superstar quant fund of the time, Long-Term Capital Management, out of business in a matter of days, saved by cash infusion organized by the Federal Reserve.

The sentiment is reminiscent of the demise of Enron, a company said to have been designed by geniuses but run by idiots. The oil-and-gas trader used next-generation financial tools designed by brilliant mathematicians. But they couldn't overcome the inept and criminal actions of the management.

The allure of a unifying, perfect mathematical formula is powerful; it is an alchemy for the enlightened age. Math's universal principles underlie and suffuse everyday life and the workings of the cosmos, offering a glimpse of the eternal. In the frequently irrational financial markets, mathematic models offer the hope of cool reason and certitude, a sort of godlike wisdom.

In the 1998 film "Pi," a troubled math genius who sees patterns in the newspaper stock tables tries to create the Algorithm for Everything. He and his work are simultaneously hunted by a Wall Street firm that seeks its predictive powers, and by orthodox Jews, who believe it could unlock the mind of God.

The quant funds thrive on volatility -- it's how they make their profit margins. But recent weeks have proved too volatile for some of the funds, many of them highly leveraged, which seemingly all at once got spooked into seeking liquidity. When they ended up seeking liquidity by selling the same stocks, the Aug. 9 plunge happened, analysts speculate, resulting in the Dow's second-largest one-day slump of the year.

"It became increasingly transparent that many of the highly sophisticated quant funds employed similar investment approaches and held similar core holdings," Thomson Financial wrote in an analysis of the role of the 25 largest quant funds in the market meltdown. "This resulted in the funds selling similar long stocks and covering similar short positions."

For instance, the most broadly held stock among the top quant shops, Thomson reported, is Exxon Mobil. Shares of the oil company dropped 2.4 percent in heavy trading during the Aug. 9 sell-off.

"If you ask the question, 'Did the smart guys blow it or get it right?' I think the answer is, if they knew it, it wouldn't have happened," said David Levine, a vice president in corporate advisory services at Thomson.

"I occasionally hear broad statements like, 'This just shows computer models don't always work,' " Clifford S. Asness, founding principal of the quant-fund firm AQR Capital Management, wrote to his clients after the sell-off. "That's true, of course, they don't, nothing always works. However, this isn't about models, this is about a strategy getting too crowded, as other successful strategies both quantitative and non-quantitative have gotten many times in the past, and then suffering when too many try to get out the same door."

The value of Simons's $29 billion Renaissance Institutional Equities Fund fell by nearly 9 percent from the beginning of the month through the Aug. 9 drop, Bloomberg News reported. It was less of a hit than many of the other quants took, possibly reinforcing Simons's status as the Dumbledore of the quants.

A mathematician and cryptanalyst, Simons headed the math department of the State University of New York at Stony Brook, pushing the program into the nation's elite.

Simons and his colleagues work in a form of high math decipherable to a handful of humans on the planet. As such, practitioners of the rare mathematic arts can become the powerful priests of investing, thanks to their strange and obscure language, much the way the medieval church trafficked in Latin, which required the translation of a learned cleric.

In 1978, Simons began to apply his predictive models to investing and set up his investment shop on the north shore of Long Island near his old school, virtually insulated from Manhattan's financial district. He generally recruits mathematicians and programmers, not MBAs and traders.

The press-shy Simons would not comment for this article, and a Renaissance spokesman could not be reached for a comment.

Via NYTimes' Tierny Lab blog, this address to the American Psychological Association.

What was the audience reaction? Did people run from the room to avoid vomiting at Baumeister's horrible remarks? Do psychologists not have an intuitive understanding of variance? Why does Baumeister take so long to explain something so mathematically simple?

R. Baumeister, Eppes Eminent Professor of Psychology & Head of Social Psychology Area, Florida State University

... I’m sure you’re expecting me to talk about Larry Summers at some point, so let’s get it over with! You recall, he was the president of Harvard. As summarized in The Economist, “Mr Summers infuriated the feminist establishment by wondering out loud whether the prejudice alone could explain the shortage of women at the top of science.” After initially saying, it’s possible that maybe there aren’t as many women physics professors at Harvard because there aren’t as many women as men with that high innate ability, just one possible explanation among others, he had to apologize, retract, promise huge sums of money, and not long afterward he resigned.

What was his crime? Nobody accused him of actually discriminating against women. His misdeed was to think thoughts that are not allowed to be thought, namely that there might be more men with high ability. The only permissible explanation for the lack of top women scientists is patriarchy — that men are conspiring to keep women down. It can’t be ability. Actually, there is some evidence that men on average are a little better at math, but let’s assume Summers was talking about general intelligence. People can point to plenty of data that the average IQ of adult men is about the same as the average for women. So to suggest that men are smarter than women is wrong. No wonder some women were offended.

But that’s not what he said. He said there were more men at the top levels of ability. That could still be true despite the average being the same — if there are also more men at the bottom of the distribution, more really stupid men than women. During the controversy about his remarks, I didn’t see anybody raise this question, but the data are there, indeed abundant, and they are indisputable. There are more males than females with really low IQs. Indeed, the pattern with mental retardation is the same as with genius, namely that as you go from mild to medium to extreme, the preponderance of males gets bigger.

All those retarded boys are not the handiwork of patriarchy. Men are not conspiring together to make each other’s sons mentally retarded.

Almost certainly, it is something biological and genetic. And my guess is that the greater proportion of men at both extremes of the IQ distribution is part of the same pattern. Nature rolls the dice with men more than women. Men go to extremes more than women. It’s true not just with IQ but also with other things, even height: The male distribution of height is flatter, with more really tall and really short men. Again, there is a reason for this, to which I shall return.

Tierney's summary:

“I’m certainly not denying that culture has exploited women,” he said. “But rather than seeing culture as patriarchy, which is to say a conspiracy by men to exploit women, I think it’s more accurate to understand culture (e.g., a country, a religion) as an abstract system that competes against rival systems — and that uses both men and women, often in different ways, to advance its cause.”

The “single most underappreciated fact about gender,” he said, is the ratio of our male to female ancestors. While it’s true that about half of all the people who ever lived were men, the typical male was much more likely than the typical woman to die without reproducing. Citing recent DNA research, Dr. Baumeister explained that today’s human population is descended from twice as many women as men. Maybe 80 percent of women reproduced, whereas only 40 percent of men did.

“It would be shocking if these vastly different reproductive odds for men and women failed to produce some personality differences,” he said, and continued:

For women throughout history (and prehistory), the odds of reproducing have been pretty good. Later in this talk we will ponder things like, why was it so rare for a hundred women to get together and build a ship and sail off to explore unknown regions, whereas men have fairly regularly done such things? But taking chances like that would be stupid, from the perspective of a biological organism seeking to reproduce. They might drown or be killed by savages or catch a disease. For women, the optimal thing to do is go along with the crowd, be nice, play it safe. The odds are good that men will come along and offer sex and you’ll be able to have babies. All that matters is choosing the best offer. We’re descended from women who played it safe.

For men, the outlook was radically different. If you go along with the crowd and play it safe, the odds are you won’t have children. Most men who ever lived did not have descendants who are alive today. Their lines were dead ends. Hence it was necessary to take chances, try new things, be creative, explore other possibilities.

The second big motivational difference between the genders, he went on, involves the kind of social relationships sought by each sex. While other researcher have argued that women are more “social” than men – more helpful and less aggressive towards others — Dr. Baumeister argued that women can be plenty aggressive in the relationships that matter most to them, which are intimate relationships. Men are more aggressive when it comes to dealing with strangers, because they’re more interested than women are in a wider network of shallow relationships.

“We shouldn’t automatically see men as second-class human beings simply because they specialize in the less important, less satisfying kind of relationship,” he said. Men are social, too, he said, just in a different way, with more focus on larger groups: “If you make a list of activities that are done in large groups, you are likely to have a list of things that men do and enjoy more than women: team sports, politics, large corporations, economic networks, and so forth.”

Sunday, August 19, 2007

Let me repeat: the meltdown is not a black swan event. Many predicted it long ago. See my post from 2005 (lots of details on CDO pricing, copula, how hedge funds could make a short term profit by taking on default risk).

All through last year, Jim Melcher saw the signs of a rapidly deteriorating American housing market — riskier mortgages, rising delinquencies and more homes falling into foreclosure. And with $100 million in assets at his hedge fund, Balestra Capital, he was in a position to do something about it.

So in October, as mortgage-backed bonds were still flying high, he bet $10 million that these bonds would plunge in value, using complex derivatives available to any institutional investor. As his gamble began to pay off in the first months of 2007, Mr. Melcher, a money manager based in New York, plowed the profits into ever bigger wagers that the mortgage crisis would worsen further, eventually risking some $60 million of the fund’s money.

“We saw the opportunity of a lifetime, and since then events have unfolded on schedule,” he said. Mr. Melcher’s flagship fund has since doubled in value, even as this summer’s market turmoil cost other investors billions, forced the closing of several major hedge funds and pushed the stock market down 7 percent since mid-July. This week, Mr. Melcher is heading to Paris for a vacation with his wife.

The extent of the turmoil has stunned much of Wall Street, but as Mr. Melcher’s case makes clear, there were ample warning signs that a financial time bomb in the form of subprime mortgages was ticking quietly for months, if not years. ...

...On Friday, the Federal Reserve was forced into a surprise cut of the discount rate it charges banks to borrow money, a move that steadied shaky stock and credit markets and reassured investors, bankers and traders who were reeling from a month of market turmoil. And for the first time, the Fed bluntly acknowledged that the credit crisis posed a threat to economic growth.

“Until recently, there was a lot of denial, but this is a big deal,” said Byron R. Wien, a 40-year veteran of Wall Street who is now chief investment strategist at Pequot Capital. “Now the big question is: Will this spill over into the broader economy?”

The answer to that question will be revealed over the coming months. But the cast of characters who missed signals like the rise of delinquencies and foreclosures is becoming easier to identify. They include investment banks happy to sell risky but lucrative mortgage debt to hedge funds hungry for high interest payments, bond rating agencies willing to hope for the best in the housing market and provide sterling credit appraisals to debt issuers, and subprime mortgage brokers addicted to high sales volumes.

What is more, some of these players now find themselves in a dual role as both enabler and victim, like the legions of individual borrowers who were convinced that their homes could only keep rising in value and were confident that they could afford to stretch for the biggest mortgage possible.

“All of the old-timers knew that subprime mortgages were what we called neutron loans — they killed the people and left the houses,” said Louis S. Barnes, 58, a partner at Boulder West, a mortgage banking firm in Lafayette, Colo. “The deals made in 2005 and 2006 were going to run into trouble because the credit pendulum at the time was stuck at easy.”

Oddly, the credit analysts at brokerage firms now being pummeled were among the Cassandras whose warnings were not heeded. “I’m one guy in a research department, but many people in our mortgage team have been suggesting that there was froth within the market,” said Jack Malvey, the chief global fixed income strategist for Lehman Brothers. “This has really been progressing for quite some time.”

Saturday, August 18, 2007

The excerpt below is from his book Bambi vs Godzilla. Is he talking about movie directors, or physicists? :-)

Trivia question: what do David Mamet, Greg Cochran, Steve Pinker and Gregory Clark (author of A Farewell to Alms) have in common?

Glengarry Glen Ross is one of my favorite movies; the scene below is an all time classic. PUT THAT COFFEE DOWN!

DAVID MAMET

I think it is not impossible that Asperger’s syndrome helped make the movies.

The symptoms of this developmental disorder include early precocity, a great ability to maintain masses of information, a lack of ability to mix with groups in age-appropriate ways, ignorance of or indifference to social norms, high intelligence and difficulty with transitions, married to a preternatural ability to concentrate on the minutiae of the task at hand.

This sounds to me like a job description for a movie director. Let me also note that Asperger’s syndrome has its highest prevalence among Ashkenazi Jews and their descendants. For those who have not been paying attention, this group constitutes, and has constituted since its earliest days, the bulk of America’s movie directors and studio heads.

Neal Gabler, in his An Empire of Their Own points out that the men who made the movies – Goldwyn, Mayer, Schenck, Laemmle, Fox, - all came from a circle with Warsaw at its center, its radius a mere two hundred miles. (I will here proudly insert that my four grandparents came from that circle).

Widening our circle to all of Eastern European Jewry (the Ashkenazim), we find a list of directors beginning with Joe Sternberg’s class and continuing strong through Seven Spielberg’s and he youth of today.

...There was a lot of moosh written in the last two decades about the “blank slate”, the idea that since each child is theoretically equal under the eyes of the law, each must, by extension be equal in all things and that such a possibility could not obtain unless each child was, from birth, equally capable – environmental influences aside – of succeeding in all things.

This is a magnificent and majestic theory and would be borne by all save those who had ever had, observed, or seriously thought about children.

Races, as Steven Pinker wrote in his refutational The Blank Slate, are just rather large families; families share genes and thus, genetic disposition. Such may influence the gene holders (or individuals) much, some, or not at all. The possibility exists, however, that a family passing down the gene for great hand-eye coordination is likely to turn out more athletes than without. The family possessing the genes for visual acuity will likely produce good hunters, whose skill will provide nourishment. The families of the good hunters will prosper and intermarry, thus strengthening the genetic disposition in visual acuity.

Among the sons of Ashkenazi families nothing was more prized than genius at study and explication.

Prodigious students were identified early and nurtured – the gifted child of the poor was adopted by a rich family, which thus gained status and served the community, the religion, and the race.

The boys grew and regularly married into the family or extended family of the wealthy. The precocious ate better and thus lived longer, and so were more likely to mate and pass on their genes.

These students grew into acclaimed rabbis and Hassidic masters, and founded generations of rabbis; the progeny of these rabbinic courts intermarried, as does any royalty, and that is my amateur Mendelian explication of the prevalence of Asperger’s syndrome in the Ashkenazi.

What were the traits indicating the nascent prodigy? Ability to retain and correlate vast amounts of information, a lack of desire (or ability) for normal social interaction, idiosyncrasy, preternatural ability for immersion in minutiae; ecco, six hundred years of Polish rabbis and one hundred of their genetic descendants, American film directors.

Thursday, August 16, 2007

says PIMCO's Bill Gross, the rich are getting too rich! The chart below shows the share of all income that went to the top .01% of earners. 15,000 families take home 1/20 of all the income in America, many enjoying a 15% tax rate!

...What pretense to assert, as did Kenneth Griffin, recipient last year of more than $1 billion in compensation as manager of the Citadel Investment Group, that "the (current) income distribution has to stand. If the tax became too high, as a matter of principle I would not be working this hard." Right. In the same breath he tells, Louis Uchitelle of The New York Times that the get-rich crowd "soon discover that wealth is not a particularly satisfying outcome." The team at Citadel, he claims, "loves the problems they work on and the challenges inherent to their business." Oh what a delicate/tangled web we weave sir. Far better to admit, as has Warren Buffett, that the tax rates of the wealthiest Americans average nearly 15% while those of their salaried and therefore less incented assistants just outside their offices are nearly twice that. Far better to recognize, as does Chart 1, that only twice before during the last century has such a high percentage of national income (5%) gone to the top .01% of American families. Far better to understand, to quote Buffett, that "society should place an initial emphasis on abundance but then should continuously strive to redistribute the abundance more equitably." ...

Now on to the credit meltdown. Gross is no "isolationist" -- he mentions the dreaded contagion. I suspect things may be more dangerous this time than in the wake of LTCM. In that case, the problems could be traced to the trades of a single firm. Today, we have trillions of (notional) dollars tied up in illiquid transactions between hundreds (if not thousands) of firms. How will this all unwind? I'll be surprised if Moody's and Standard and Poors aren't dragged into court over some of their AAA ratings. But who can blame them if their models (based on historical default probabilities) told them that senior tranches would never bear any losses? (See also here.)

...Some wonder what squelched the hunger of potential lenders so abruptly, while in the same breath suggesting that the subprime crisis is "isolated" and not contagious to other markets or even the overall economy. Not so, and the sudden liquidity crisis in the high yield debt market is just the latest sign that there is a connection, a chain that links all markets and ultimately their prices and yields to the fate of the U.S. economy. The fact is that several weeks ago, Moody’s and Standard & Poor’s finally got it into gear, downgrading hundreds of subprime issues and threatening more to come. "Isolationists" would wonder what that has to do with the corporate debt market. Housing is faring badly but corporate profits are in their prime and at record levels as a percentage of GDP. Lenders to corporations should not be affected by defaults in subprime housing space, they claim. Unfortunately that does not appear to be the case.

As Tim Bond of Barclays Capital put it so well a few weeks ago, "it is the excess leverage of the lenders not the borrowers which is the source of systemic problems." Low policy rates in many countries and narrow credit spreads have encouraged levered structures bought in the hundreds of millions by lenders, in an effort to maximize returns with what they thought were relatively riskless loans. Those were the ABS CDOs, CLOs, and levered CDO structures that the rating services assigned investment grade ratings to, which then were sold with enticing LIBOR + 100, 200, 300 or more types of yields. The bloom came off the rose and the worm started to turn, however, when institutional investors – many of them foreign – began to see the ratings downgrades in ABS subprime space. Could the same thing happen to levered structures with pure corporate credit backing? To be blunt, they seem to be thinking that if Moody’s and Standard & Poor’s have done such a lousy job of rating subprime structures, how can the market have confidence that they’re not repeating the same structural, formulaic, mistake with CLOs and CDOs? That growing lack of confidence – more so than the defaults of two Bear Stearns hedge funds and the threat of more to come – has frozen future lending and backed up the market for high yield new issues such that it resembles a constipated owl: absolutely nothing is moving. ...

Is the Fed out of touch with what is happening in the markets? Bloomberg: Poole Says `Real Economy' Unhurt by Subprime Collapse. Umm... isn't the important question what impact current events will have on the economy going forward? Poole may be looking at lagging indicators. I think Greenspan was much more aware of the role fragile psychology -- i.e., investor, consumer and executive confidence -- plays in the functioning of the economy.

``A possible consequence of the repricing of risk assets would be the failure and disorderly liquidation of a hedge fund or other institution of sufficient size as to disrupt markets, as LTCM threatened to do in 1998,'' Mahoney said.

Credit markets started falling in June as two Bear Stearns Cos. hedge funds collapsed because of bad subprime bets. Goldman Sachs Group Inc., the world's most profitable securities firm and second-largest hedge fund manager, was forced to put $2 billion of its own money into one of its hedge funds and waive some fees after the fund lost 28 percent of its value this month.

Basis Capital Fund Management Ltd. yesterday told investors losses at one of its hedge funds may exceed 80 percent as the U.S. subprime mortgage rout prompted creditors to force the Sydney-based company to sell assets.

Let R = the ratio of number of artificially intelligent virtual beings to the number of "biological" beings (humans). The virtual beings are likely to occupy the increasingly complex virtual worlds created in computer games, like Grand Theft Auto or World of Warcraft (WOW will earn revenues of a billion dollars this year and has millions of players). In the figure below I have plotted the likely behavior of R with time. Currently R is zero, but it seems plausible that it will eventually soar to infinity. (See previous posts on the Singularity.)

If R goes to infinity, we are overwhelmingly likely to be living in a simulation...

Think of the ratio of orcs, goblins, pimps, superheroes and other intelligent game characters to actual player characters in any MMORPG. In an advanced version, the game characters would themselves be sentient, for that extra dose of realism! Are you a game character, or a player character? :-)

By the way, the author of the article John Tierney gives the simulation idea a probability P of greater than 50%, while Bostrom, the Oxford philosopher who apparently thinks about this stuff as his day job, gives it about 20%. To me it's not implausible, but keep in mind: if you are *inside* the simulation your local conditions in principle tell you nothing about the outside world in which the simulation runs. So, we basically know nothing about P unless (1) we just happen to be in a realistic historical simulation or (2) we haven't yet hit the singularity. (2) is of course highly unlikely if R does go to infinity -- we'd be in a very special subset of sentient beings. So I'd say it's unlikely that our estimate of P is very good.

NYTimes: ...Dr. Bostrom assumes that technological advances could produce a computer with more processing power than all the brains in the world, and that advanced humans, or “posthumans,” could run “ancestor simulations” of their evolutionary history by creating virtual worlds inhabited by virtual people with fully developed virtual nervous systems.

Some computer experts have projected, based on trends in processing power, that we will have such a computer by the middle of this century, but it doesn’t matter for Dr. Bostrom’s argument whether it takes 50 years or 5 million years. If civilization survived long enough to reach that stage, and if the posthumans were to run lots of simulations for research purposes or entertainment, then the number of virtual ancestors they created would be vastly greater than the number of real ancestors.

There would be no way for any of these ancestors to know for sure whether they were virtual or real, because the sights and feelings they’d experience would be indistinguishable. But since there would be so many more virtual ancestors, any individual could figure that the odds made it nearly certain that he or she was living in a virtual world.

The math and the logic are inexorable once you assume that lots of simulations are being run. But there are a couple of alternative hypotheses, as Dr. Bostrom points out. One is that civilization never attains the technology to run simulations (perhaps because it self-destructs before reaching that stage). The other hypothesis is that posthumans decide not to run the simulations.

“This kind of posthuman might have other ways of having fun, like stimulating their pleasure centers directly,” Dr. Bostrom says. “Maybe they wouldn’t need to do simulations for scientific reasons because they’d have better methodologies for understanding their past. It’s quite possible they would have moral prohibitions against simulating people, although the fact that something is immoral doesn’t mean it won’t happen.”

Dr. Bostrom doesn’t pretend to know which of these hypotheses is more likely, but he thinks none of them can be ruled out. “My gut feeling, and it’s nothing more than that,” he says, “is that there’s a 20 percent chance we’re living in a computer simulation.”

My gut feeling is that the odds are better than 20 percent, maybe better than even. I think it’s highly likely that civilization could endure to produce those supercomputers. And if owners of the computers were anything like the millions of people immersed in virtual worlds like Second Life, SimCity and World of Warcraft, they’d be running simulations just to get a chance to control history — or maybe give themselves virtual roles as Cleopatra or Napoleon. ...

Saturday, August 11, 2007

A mutation in the gene for the α2b-adrenoceptor improves the formation of memories of strong emotional events. Students in Zurich with the mutation performed twice as well on a controlled test. Rwandan refugees with the mutation tended to suffer significantly more often from flashbacks of traumatic events. So, the mutation affects cognitive function in a clear way. It's also distributed unevenly among different populations -- 30% of Swiss and 12% of Rwandans have the mutant allele.

Economist: ...Rare events that might have an impact on an individual's survival or reproduction should have a special fast lane into the memory bank—and they do. It is called the α2b-adrenoceptor, and it is found in the amygdala, a part of the brain involved in processing strong emotions such as fear. The role of the α2b-adrenoceptor is to promote memory formation—but only if it is stimulated by adrenaline. Since emotionally charged events are often accompanied by adrenaline secretion, the α2b-adrenoceptor acts as a gatekeeper that decides what will be remembered and what discarded.

However, the gene that encodes this receptor comes in two varieties. That led Dominique de Quervain, of the University of Zurich, to wonder if people with one variant would have better emotional memories than those with the other. The short answer, just published in Nature Neuroscience, is that they do. Moreover, since the frequencies of the two variants are different in different groups of people, whole populations may have different mixtures of emotional memory.

...in his first experiment. This involved showing students photographs of positive scenes such as families playing together, negative scenes such as car accidents, and neutral ones, such as people on the phone. Those students with at least one gene for the rarer version of the protein (everyone has two such genes, one from his father and one from his mother) were twice as good at remembering details of emotionally charged scenes than were those with only the common version. When phone-callers were the subject, there was no difference in the quality of recall.

That is an interesting result, but some of Dr de Quervain's colleagues at the University of Konstanz, in Germany, were able to take it further in a second experiment. In fact, they took it all the way along a dusty road in Uganda, to the Nakivale refugee camp. This camp is home to hundreds of refugees of the Rwandan civil war of 1994.

In this second experiment the researchers were not asking about photographs. With the help of specially trained interviewers, they recorded how often people in the camp suffered flashbacks and nightmares about their wartime experiences. They then compared those results with the α2b-adrenoceptor genes in their volunteers. As predicted, those with the rare version had significantly more flashbacks than those with only the common one.

Besides bolstering Dr de Quervain's original hypothesis, this result is interesting because only 12% of the refugees had the rarer gene. In Switzerland, by contrast, 30% of the population has the rare variety—and the Swiss are not normally regarded as an emotional people.

Also, Dyson is sceptical about global warming, but knows enough to be sceptical of his scepticism.

Bad Advice to a Young Scientist

Sixty years ago, when I was a young and arrogant physicist, I tried to predict the future of physics and biology. My prediction was an extreme example of wrongness, perhaps a world record in the category of wrong predictions. I was giving advice about future employment to Francis Crick, the great biologist who died in 2005 after a long and brilliant career. He discovered, with Jim Watson, the double helix. They discovered the double helix structure of DNA in 1953, and thereby gave birth to the new science of molecular genetics. Eight years before that, in 1945, before World War 2 came to an end, I met Francis Crick for the first time. He was in Fanum House, a dismal office building in London where the Royal Navy kept a staff of scientists. Crick had been working for the Royal Navy for a long time and was depressed and discouraged. He said he had missed his chance of ever amounting to anything as a scientist. Before World War 2, he had started a promising career as a physicist. But then the war hit him at the worst time, putting a stop to his work in physics and keeping him away from science for six years. The six best years of his life, squandered on naval intelligence, lost and gone forever. Crick was good at naval intelligence, and did important work for the navy. But military intelligence bears the same relation to intelligence as military music bears to music. After six years doing this kind of intelligence, it was far too late for Crick to start all over again as a student and relearn all the stuff he had forgotten. No wonder he was depressed. I came away from Fanum House thinking, “How sad. Such a bright chap. If it hadn’t been for the war, he would probably have been quite a good scientist”.

A year later, I met Crick again. The war was over and he was much more cheerful. He said he was thinking of giving up physics and making a completely fresh start as a biologist. He said the most exciting science for the next twenty years would be in biology and not in physics. I was then twenty-two years old and very sure of myself. I said, “No, you’re wrong. In the long run biology will be more exciting, but not yet. The next twenty years will still belong to physics. If you switch to biology now, you will be too old to do the exciting stuff when biology finally takes off”. Fortunately, he didn’t listen to me. He went to Cambridge and began thinking about DNA. It took him only seven years to prove me wrong. The moral of this story is clear. Even a smart twenty-two-year-old is not a reliable guide to the future of science. And the twenty-two-year-old has become even less reliable now that he is eighty-two.

A gentle introduction below by Floyd Norris from the Times. The bottom line is that no one knows what the real default probabilities are for different classes of mortgages or corporate debt -- it may turn out in the long run that investors paid a fair price even for risky tranches. A lot depends on Helicopter Ben Bernanke and whether the liquidity crisis spreads to the currently robust broader economy.

What has suddenly changed is the market's collective attitude toward risk -- we basically had what physicists call a phase transition from historically low risk premia to more normal risk premia. I'd guess most of the hedge funds that have lost money recently weren't entirely stupid -- they were expecting spreads to widen, but they bet on correlations that have yet to be realized in the first indiscriminate reaction of the market. Nevertheless, they should have remembered how "contagion" works in financial markets. Those that can weather the storm may be ok in the end; the rest will end up like LTCM.

SUDDENLY it’s not so easy to borrow.

Only two months ago, it seemed as if almost any company could borrow money at low interest rates. Now loans seem to be drying up everywhere.

What had seemed like a contained problem, involving home loans to people with poor credit, has suddenly mushroomed into a rout that threatens to make life difficult for everyone who needs to borrow money.

Home buyers are likely to pay more for mortgages, and some with less-than-pristine credit or an inability to come up with a down payment may find they no longer can borrow at all.

A German bank had to be rescued by other banks last week, because it had speculated in securities backed by American mortgages. One of the biggest mortgage lenders in the United States collapsed, and another said it would drastically scale back its lending because it cannot find investors willing to finance the loans it makes.

The volume of new high-yield bonds — also known as junk bonds — fell by 89 percent in July. The market for loans to highly leveraged companies has almost dried up. Standard & Poor’s counts $35 billion in corporate loans that have been delayed or canceled, including loans to finance the leveraged buyout of Chrysler.

The Chrysler deal will go through, because banks had promised to lend the money if others would not take the loans. But from now on there are likely to be fewer corporate takeovers, and those that do take place are likely to be at lower prices. “This is a classic credit correction,” said Jack Malvey, the chief global fixed income strategist for Lehman Brothers. “The magnitude of risk was significantly underappreciated.”

Mutual fund investors have been pulling back rapidly, with more than $1.3 billion coming out of funds that invest in leveraged loans during recent weeks, and $2.7 billion leaving funds that buy high-yield bonds, according to AMG Data Services.

Hedge funds, which had been major buyers of complicated securities that financed leveraged loans and mortgages, have also pulled back. Some investors have tried to pull money out of such hedge funds, leading Bear Stearns to stop investors from making withdrawals from three of its funds.

“That is the core of a financial crisis, when too many people head to the exits simultaneously,” said Robert Bruner, the dean of the business school at the University of Virginia.

Mr. Bruner is the co-author of a book on the Panic of 1907, to be published next month, and he sees similarities between then and now. “It was a time marked by the rise of new financial institutions and new financial instruments,” he said. “It marked the end of a period of extraordinary growth, from 1895 to 1907.”

The credit market has changed drastically in recent years, as banks grew far less important and credit rating agencies like Standard & Poor’s and Moody’s became the essential players in the new financial architecture.

Many loans, whether mortgages or loans to corporations, were financed by selling securities. It was the credit agency ratings that determined if those securities could be sold, and deals were structured to meet the criteria set by the agencies.

Those criteria turned out to be very generous. The agencies figured that even very risky loans were unlikely to cause big losses, and so most of the securities backed by loans to poor credit risks could get AAA ratings — the highest available — as long as those securities had first claim on loan payments. Investors bought the securities thinking they were completely safe, and some did so with borrowed money.

Now, however, there is fear even about those securities. The rating agencies are changing their criteria for the loans, and many investors no longer trust the ratings.

The markets are “very panicked and illiquid,” said Mike Perry, the chief executive of IndyMac Bank, the ninth largest mortgage lender in the first half of this year, as he announced plans last week to curtail lending sharply. It is very difficult, he said, to find buyers even for the AAA securities.

All this has happened with few defaults. Mortgage delinquencies are up, particularly on loans made in 2006 when credit standards were very low, but the real problem is that lenders and investors fear things will get much worse.“This is what we would characterize as the first correction of the modern neo-credit market,” said Mr. Malvey of Lehman Brothers. “We’ve never had a correction with these types of institutions and these types of instruments.”

It now seems likely that the rating agencies, and investors, were lured into a false sense of security by the lack of defaults. With the value of homes, and companies, rising, it was usually possible for a borrower in trouble to refinance the debt or, at worst, sell the home or business. Either way, lenders got paid.

Now, there is less confidence that rising prices will bail out lenders, and there is doubt not only about the quality of old loans but also about important parts of the new financial system.

“The markets seem to be expressing concern about the performance and the stability of hedge funds and, to a lesser extent, private equity funds,” said Mr. Bruner.

The credit squeeze is coming at a time when the American economy seems to be growing, despite problems in the housing market, and the world economy is strong. “The underlying economy is very healthy,” said Henry Paulson, the Treasury secretary, as he visited China last week. But a good economy in no way precludes credit problems. In fact, it is during good economic times that credit standards are most likely to be so lax that bad loans are made.

“Financial panics don’t happen during depressions,” said James Grant, the editor of Grant’s Interest Rate Observer. “They happen on the brink of depressions. The claim the world is prosperous is beside the point.”

Not all panics lead to economic downturns, of course, and if this one continues pressure will grow on the Fed and other central banks to lower the short-term interest rates they control and thus stimulate the economy.

But central banks do not always determine what happens in credit markets.

“The Fed tightened in 2005 and 2006, but creative financing on Wall Street blunted the impact,” said Robert Barbera, the chief economist of ITG, a research firm. “The collapse of that option in the last 90 days means the entirety of that tightening is arriving now, and there is a violent tightening going on.”

Of course, this phase will pass. The insurance companies and pension funds that are the traditional buyers of bonds always have money coming in, from interest payments and bond maturities, as well as from new business, and they will have to put it to work.

“The history is that lenders move in great caravans between two extreme points, which we can call stringency and accommodation,” said Mr. Grant, recalling how hard it was for companies to get loans as recently as 2002.

Lenders will move back to accommodation one day, he said, but for now it appears that risky borrowers,whether of the corporate or individual variety, will discover that it’s much more difficult to find someone to lend money to them.

Friday, August 10, 2007

For every loser, there has to be a winner :-) What I don't understand is why anyone would be long these indices...

Note the article claims that it's the dumb foreigners -- European and Asian financial institutions -- holding the worst tranches of ABX. Perhaps this has something to do with the ECB injecting more liquidity into the European banking system today than in the wake of 9/11.

I suppose the real winners are people who got inexpensive mortgages, as well as the builders and mortgage brokers who made out during the liquidity-driven housing bubble of the last few years. Nevertheless, you can track the antics of the credit meltdown by following the indices discussed below.

Forbes: A consortium of the nation's leading investment banks have quietly created an index that is not only protecting them against the recent market meltdown but also promising to make them bundles of money in the process.

The index, known as LCDX, was created just weeks before the meltdown began by shrewd financial operatives like JPMorgan Chase (nyse: JPM - news - people ) and Goldman Sachs (nyse: GS - news - people ), which suspected trouble was brewing in the leveraged loan market and needed a way to protect themselves and their hedge fund clients.

This was just-in-time financial engineering. On May 23, LCDX, a credit derivatives contract covering the potential default of 100 large corporate names, made its debut at 100.5. Rising interest rates, widespread fear about the fallout from the subprime mortgage fiasco, and an overhang of $250 billion in private equity loans that had to be refinanced triggered a vicious tumble in the stock market.

By late June, as fears about the extent of the subprime mortgage fiasco spread, the LCDX began to weaken, and those who'd shorted it began making money. Hedge funds loaded to the gills with leveraged buyout loans saw it as a way of hedging their positions, as the cash market in those loans was relatively illiquid.

Goldman Sachs has hedged a large percentage of its $72 billion in obligations, including private equity commitments. Bear Stearns (nyse: BSC - news - people ) reported last Friday it was "making money on hedges related to some large leveraged buyout loans ... or has been selling at lower prices than anticipated."

The leveraged loan market is not the only sector of the fixed-income market where the investment banks shrewdly created an index that would help them hedge against one of their most profitable but risky businesses--the issuance of asset-backed securities like the mortgage bonds used to finance the subprime housing market.

In early 2006 a small number of firms led by Deutsche Bank (nyse: DB - news - people ), Barclays (nyse: BCS - news - people ), Bear Stearns and Goldman Sachs formed the ABX index (a credit default swap of asset-backed mortgages) of 30 most liquid mortgage-backed bonds. The savviest players like Deutsche Bank (which reportedly made $250 million) and several hedge funds on both sides of the Atlantic began shorting that ABX index in early 2006 at par. It now sells at 35, implying that the value of those mortgage-backed bonds and others of their ilk have lost 65% of their value, a potential loss in the tens of billions of dollars. Which means, of course, that smart money's made up to 65% on this one trade.

Indeed, Deutsche Bank derivatives research has been warning clients for months that the leverage in the asset-backed market, especially the collateralized debt obligations set up to hold pools of subprime mortgage-backed securities, had far too much embedded leverage--up to 100 times too much.

...Sunil Hirani, founder of Creditex, says, "If we did not have these credit derivative default indexes--LCDX, CDX, iTraxx Crossover, and others--the credit markets would be functioning with even more volatility, as everyone would be in the dark about pricing and the way to disperse risk." Creditex is a major factor in the credit derivative market.

Of course, it also means there are a lot of folks quietly making a bundle of money while the markets crater. Moreover, no regulatory authority has to approve the creation of these indexes. Nor is there widespread transparency of the trading or price action in these indexes.

Markit, a British company 60% owned by a number of these investment banks, administers the market in credit derivative swaps and posts an average price for each contract at the end of the trading session on Markit.com. A few firms like JPMorgan send their clients daily research updates on the markets and recommend when to buy and when to sell. The Wall Street Journal and the Financial Times have begun to publish a few of the index prices.

There is some concern that the current volatility in the credit markets is due to the lack of liquidity in these indexes. But Markit officials believe about $200 billion of LCDX has traded since May 23. And Hirani says his firm has been doing $20 billion of business in the $100 billion daily volume in the iTraxx Crossover index, which is the index for 100 large European companies.

Still, some of this volume could be hedge funds or investment banks trading in and out of the market to make a few points. LCDX, the credit derivative that is fast becoming the most popular of these, is bound to be volatile, as it includes loans issued by Ford Motor (nyse: F - news - people ) and United Airlines. In September a revised index will include the loans of prospective buyouts like Alcatel, Tribune (nyse: TRB - news - people ) and Chrysler. Since the collateralized loan obligations market is frozen at this time, it means the only way a hedge fund or investment firm with losses in the corporate loan market can protect itself is to go short on these indexes, which is where the big money truly lies.

To be sure, much of this is a zero sum game, which means that for every winner on the short side, there is a loser on the long side. European and Asian financial institutions are believed to have been the unsuspecting buyers of the riskiest tranches of the ABX index, for instance.

Lately, the most extreme risk appears to be for mortgages issued in the commercial real estate market in the U.S., which is the province of an index that began trading in April, the CMBX, to be followed soon by CMBX Europe, an index of commercial real estate loans in Europe. This could mean the hedge fund fraternity believes commercial real estate mortgages have been sold at an inflated price level there was well.

Brad Setser's recent blog post is a wonderful overview of the present balance of financial terror between the US and China -- we buy their products, they finance our profligate spending. I used to post a lot on this topic, but I stopped after a while since I thought all the issues had been laid out and nothing was changing. Brad summarizes the latest developments -- the threat of new trade legislation making its way through Congress, and growing public recognition in China that it isn't in their interest to continue accumulating such huge ( > $1 trillion) positions in US debt.

The other day I was listening to Jim Cramer's CNBC armageddon rant and one little thing that shocked me was his explicit claim that the Fed was afraid to cut rates because of what it would do to the dollar. That brought back to me the doubly precarious position markets are in -- on top of the sudden liquidity crises in credit/housing we also have the real possibility of a dollar meltdown if the Fed steps in to cushion the landing.

Setser: ...He Fan (of the Chinese Academy of Social Sciences) published an oped in the China daily suggesting that China might sell (one day) some of its treasuries. Xia Bin (director of the State Council Development Research Center) suggested that China should use its financial leverage to keep a few “silly senators” from setting US-Chinese economic policy. Treasury Secretary Hank Paulson dismissed the risk that China would ever cut off its financing of the US. Chinese financing became an issue in the Presidential campaign. Barack Obama, for example, picked up on Bill Clinton’s (effective) 2004 line on China: "It's pretty hard to have a tough negotiation when the Chinese are our bankers."

CNBC switched from discussing which US company China’s investment authority (or its big banks) might buy next to discussing the possibility that China might not buy any US financial assets at all.

And cool heads – Michael Pettis of Peking University's Guanghua School of Management, for example – appealed for calm.

The general consensus in the US is that China cannot cut off the US without “shooting itself in the foot."

"China would be shooting itself in the foot,'' said Greg Gibbs, a currency strategist at ABN Amro Holding NV in Sydney. ``

I disagree. At least in part.

China is already shooting itself in the foot – financially speaking. It loses money every time it buys another dollar bonds. The dollar will depreciate against the RMB some day, leaving China – which finances its purchase of dollars by selling RMB-denominated debt – with large losses.

And, generally speaking, adding to a losing position adds to your ultimate losses.

China would be better off financially if it let the RMB appreciate substantially, stopped financing the US and took large losses now rather than continuing to finance the US, adding to its stock of dollars and adding to the scale of its future losses. A bank that is lending to a failing company reduces its ultimate loss by cutting the company off and taking its lumps now, not by covering ever bigger losses with new loans to avoid “turmoil.” China is in a similar position. The US isn’t a failing company, but China is lending to the US on terms that imply very large financial losses for China.

China’s real problem is that it cannot stop financing the US without shooting its own exporters’ in the foot.

Up until now, China’s exporting interests (perhaps in conjunction with all those who benefit from loose monetary policy) have driven Chinese policy. But the interests of China’s exporters aren’t quite the same as the interests of China writ large.

By the same token, the interest of US firms with operations in China – or US firms that rely on Taiwanese and Hong Kong firms with supply chains that stretch back into China -- aren’t quite the same of the interests of the US as whole. There are parts of the US economy that have benefited from China’s policy of subsidizing US consumption, and US borrowing, but there are also parts that haven’t.

This discussion isn’t purely academic. It provides the context for understanding He Fan’s now famous article in the China daily. He Fan’s writings leave no doubt that he understands the financial risks that China is taking by holding so many dollar-denominated assets. Dr. He and Dr. Zhang of the Chinese Academy of Social Sciences wrote in 2006 (in an early verion of this -- now restricted -- paper):

“Large amounts of trade surplus and foreign exchange reserves have put Asian economies in a position as hostage. Once the global imbalance is adjusted in an unexpected manner, such as sudden drop in the US dollar exchange rate, East Asian economies will be confronted with [a] huge loss.”

He and Zhang think China should adjust its policy to reduce its exposure to the United States. They write:

“continuous growth of [Asia’s] trade surplus is harmful and dangerous …. China’s enlarging trade surplus is closely related with distorted income distribution, losing of job opportunities and disproportional development between [the] manufacturing and [the] services sector. … to absorb the excessive liquidity caused by the increase in foreign exchange reserves, monetary authorities in East Asia [have] to continuously rely on sterilization measure[s], thus limit[ing] the room for monetary policies.”

Their arguments are in many ways the mirror image of arguments that I have made in the past. They don’t think a policy that increases China’s large exposure to the US dollar is in China’s long-term interest, even though it helps China’s export sector. I don’t think a set of policies that leaves the US ever-more dependent on Chinese financing is in the United States interest, even though China’s subsidy of US borrowing unquestionably helps many in the US.

The possibility that China might cut the US off is remote – barring a confrontation over Taiwan. But it also isn’t totally beyond the realm of possibility that China might someday change a policy that many in China think benefits the US more than it benefits China. That is one reason why the balance of financial terror may not be quite as stable as it now seems. The costs associating with maintaining the status quo – most notably the costs associated with China’s huge dollar position – are growing, not falling. ...

Thursday, August 09, 2007

Anyone read The Black Swan yet? I liked his earlier book Fooled By Randomness. I skimmed the Black Swan at the bookstore and liked it as well but was too cheap to part with the $20 :-) Here is an earlier post, linking to a nice podcast interview in which he discusses prediction and the dismal track record of certain prognosticators.

Taleb: "There are a lot of disciplines -- economics, political science -- where the expert is no expert. ... They don't have more predictive power than cab drivers ... do not take the experts seriously in these areas..." (He says this both on the podcast and on Charlie, but I quote from the latter. He's exaggerating -- remember his market perspective -- but not entirely wrong :-)

By the way, the current seizing up of the credit markets is not a black swan event -- a lot of people predicted it a long time ago!

Monday, August 06, 2007

Anyone looking to hire a PhD quant? Someone I know is moving from theoretical physics to finance. Below is a partial resume. The candidate is 100% fluent in both English and Mandarin, easygoing, hardworking and a nice guy. I've edited a little to preserve privacy.

Conjectured a new weakly interacting particle to explain an anomaly in experimental data and suggested new processes to test the conjecture

2001-2004: Postdoctoral research associate at the Argonne National Laboratory, Argonne, IL

Performed a state of the art high order calculation of the production probability of a supersymmetric (SUSY) particle. Combined both analytical and numerical evaluations to achieve singularity cancellation and integrated over multi-dimensional phase space using Monte Carlo

Proposed new ways of breaking large Lie groups in higher space dimensional models and constructed the first dynamical breaking of SO(10) group via deconstruction

Designed the best way to determine one of the most important SUSY parameters with different experimental input

1997-2001: Research assistant at the University of Wisconsin, Madison, WI

Led several projects in calculating production probabilities of Higgs boson and SUSY particles

Wrote the standard reference in determining the SUSY charge and parity violating phase through electric dipole moments. Sampling of up to 26 dimensional parameter space was done using Monte Carlo simulation

Solved Einstein’s equation in high dimensional Anti de Sitter space

Publications

28 scientific papers published in top international journals, with more than 590 citations

If this is at all accurate -- specifically about their taking short positions in subordinated credit to offset losses in senior debt, and only investing in entities with strong balance sheets -- then, Citadel will probably make a killing in the long run, having bought out their positions. It sounds like Sowood called the general direction of the credit market correctly (overall deterioration and widening of spreads), but the detailed correlations behind their trades were not realized.

I understand Harvard Management Corp lost hundreds of millions on their Sowood investment.

Note to self: remember that markets can be indiscriminate and irrational for long periods of time :-/

Transcript of Remarks By Jeff Larson, Managing Partner

Sowood Capital Management LP

Investor Conference Call

August 3, 2007

2pm Eastern Standard Time

INTRODUCTION

Good afternoon. This is Jeff. This call is extremely difficult. You entrusted us...

WHAT HAPPENEDHow did we get here?

In the twelve month period ending this June, our returns were roughly 16%, a very substantial portion of those returns were in credit related positions, mostly credit vs. equity. In pursuing this strategy earlier this year, we began to build positions in companies whose senior or bankdebt was well cushioned with subordinated debt and backed by strong collateral, and with projected healthy recovery rates even in a default scenario. In many cases we hedged these positions by shorting subordinated debt, equity or both, in the belief that if credit spreads widened for senior or secured debt, they would widen much more for the subordinated debt and/or be accompanied by a decline in the company's share price.

We believed this strategy positioned us to benefit from a deterioration in subordinated credit relative to senior credit and justified the increased leverage it entailed. As we examined each investment and individual corporation, we saw relatively strong balance sheets, little to no chance of loss even in default, no near term liquidity pressures, and no fundamental reason to expect extraordinary widening in those corporate credit spreads. As we looked at these opportunities, in select cases where we were particularly confident in our analysis, we built some concentrated positions.

[credit spreads widened ... blah blah... positions deteriorated...]

In response to these developments, we took measures to further reduce our net credit risk, to cut positions were we could, and to create liquidity by both unwinding capital intensive credit positions and trimming our risk arb book. Unfortunately, these measures were not enough to withstand the events of the following week, beginning July 23. The deterioration in corporate credit accelerated even more sharply during the week of July 23. Each day brought greater and greater losses. As those losses increased during the week, we continued our efforts to reduce exposures and raise cash to meet anticipated margin calls...

...Silicon Valley is thick with those who might be called working-class millionaires — nose-to-the-grindstone people like Mr. Steger who, much to their surprise, are still working as hard as ever even as they find themselves among the fortunate few. Their lives are rich with opportunity; they generally enjoy their jobs. They are amply cushioned against the anxieties and jolts that worry a vast majority of people living paycheck to paycheck.

But many such accomplished and ambitious members of the digital elite still do not think of themselves as particularly fortunate, in part because they are surrounded by people with more wealth — often a lot more.

When chief executives are routinely paid tens of millions of dollars a year and a hedge fund manager can collect $1 billion annually, those with a few million dollars often see their accumulated wealth as puny, a reflection of their modest status in the new Gilded Age, when hundreds of thousands of people have accumulated much vaster fortunes.

“Everyone around here looks at the people above them,” said Gary Kremen, the 43-year-old founder of Match.com, a popular online dating service. “It’s just like Wall Street, where there are all these financial guys worth $7 million wondering what’s so special about them when there are all these guys worth in the hundreds of millions of dollars.”

Mr. Kremen estimated his net worth at $10 million. That puts him firmly in the top half of 1 percent among Americans, according to wealth data from the Federal Reserve, but barely in the top echelons in affluent towns like Palo Alto, Menlo Park and Atherton. So he logs 60- to 80-hour workweeks because, he said, he does not think he has nearly enough money to ease up.

“You’re nobody here at $10 million,” Mr. Kremen said earnestly over a glass of pinot noir at an upscale wine bar here.

...A few even choose to jump off the golden treadmill.

That is what Mark Gage, 51, an engineer, and his wife, Meredith, did when they left the Bay Area in 2005 with $3 million or so in assets. They bought a house in Bend, Ore. — “a bigger, much nicer home with dramatic views” — and now Mr. Gage works only when the perfect consulting job presents itself.

Yet the same drive that earned so many of the engineers and entrepreneurs who live here their fortunes keeps them tied to the Valley, which resembles nothing so much as a sprawling post-war suburb, though one whose roadways are thick with cars costing in the six figures.